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Carry Trade Aggravates the Oil Shock



The recent oil price shocks should be serving as another cautionary lesson for the world's major central banks and their misguided interest rate policies. The question is whether they will listen.

At present all major central banks maintain negative real interest rates, even though annualized inflation in the eurozone rose to 2.6 percent in March. Yet there are still protests against the European Central Bank's intention to raise its leading rate of 1.0 percent to 1.25 percent a year next week, while the US Federal Reserve and the Bank of Japan maintain zero interest rates. Permanently negative real interest rates distort world financial markets dangerously. Central banks should face reality and raise their rates faster and higher.

Loose monetary policy can only stimulate economic growth if other conditions for growth are in place. Today, much excess capital goes abroad as carry trade to emerging markets where investment conditions are more lucrative, destabilizing all kinds of markets. Princeton Professor Hyun Song Shin has used the net non-core dollar liabilities of 160 foreign banks in the United States, as an assessment of a major part of the carry trade. Currently, it amounts to $600 billion. By coincidence, that is accidentally exactly the volume of the US Federal Reserve's second quantitative easing. This money does not stimulate the US economy as investment or consumer demand. The outcome is instead a demand shock that destabilizes the global economy, prompting policymakers in emerging economies to complain about currency wars and capital inflows causing overheating.

Mainstream economists are still in the thrall of what they perceive to be the need to stimulate the economy through low interest rates because of a large output gap evident in sizeable unemployment. But the world has now seen negative real interest rates for two and a half years, and global growth last year was 5 percent, which is the historical maximum. Much of the purported output gap is an illusion, reflecting that many obsolete factories in the old world have lost out to more competitive ones in emerging markets. Since the structural changes require large-scale retraining, unemployment is likely to stay high for years.

Rather than investing in the West, international investors are pursuing carry trade on a larger scale than ever. In the last year, two favorite trades have been financial investment in emerging market assets and commodities. Since the borrowed money is available for only a short time, these investments have to be of brief durability, boosting prices rather than production capacity. International investors utilize cheap credit, especially from the United States, for carry trade, investing in assets whose prices rise the most. Until November last year, it was mainly in emerging markets. Now, raw materials, food, oil, metals and gold are the new favorites.

When agricultural produce grew scarce last year because of drought in Russia and Australia, food became a popular carry trade. Rising food prices have contributed to riots and social tension in many developing countries, not least in North Africa, with significant political consequences. Increasing food price subsidies are also threatening to undermine financial stability in such countries.

Carry trade may not have caused the current unrest in the North Africa, but it has contributed. The political instability, in turn, has subsequently depressed asset markets in the Middle East. The surplus liquidity has to find other more profitable outlets than emerging market assets, and real investment in the sluggish Western economies do not necessarily come to mind.

Given the dearth of investment objects, carry trade is now concentrating on commodities, especially oil and gold, the prices of which continue to surge. After the turbulence started in the Middle East, oil has become especially attractive because of declining production in Libya and more political disturbances appear likely. With new exchange traded funds for both oil and gold, also retail investors can participate in this carry trade. Therefore, the oil market is not only suffering from a supply shock, but also a demand shock.

The consequences of the current extremely loose Western monetary policy have become all too clear: The lower the official interest rates are, the higher the oil price will soar. Excess liquidity is not likely to help but hamper the over-stimulated yet underperforming Western economies, whose biggest current threat is the sharply rising oil price.

Mainstream monetary economists disdainfully discard headline inflation and tell us to ignore food and energy prices and focus on core inflation. But that really means a focus on non-inflationary goods and services. Well, if inflation targeting is to make sense, it must focus on actual inflation, the kind that affects the daily lives of citizens.

Monetary stimulation has been tried for too long and it did not work. Instead, in the early and middle part of the last decade, it led to a catastrophic asset bubble and bust. On average, the United States has had a slightly negative real interest rate since 2002, measured as the federal fund rate minus the consumer price inflation. It is time to pay more attention to financial stability than illusory output gaps and to blame the key culprits, the permissive central bankers, before they cause more damage.

The Bank of England, the ECB and the US Federal Reserve ought to hike their interest rates early and fast to salvage output in their jurisdictions from an aggravated oil shock.

Anders Åslund is a senior fellow of the Peterson Institute for International Economics and his latest book is "The Last Shall Be the First: The East European Financial Crisis."

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